Business Cycles of the Capitalist System: Meaning, Characteristics, Phases and Other Information

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Business cycle or trade cycle is a part of the capitalist system. It refers to the phenomenon of cyclical booms and depressions. In a business cycle, there are wave-like fluctuations in aggregate employment, income, output and price level. The term business cycle has been defined in various ways by different economists.

Contents

1. Meaning

2. Characteristics of Business Cycles

3. Phases of a Business Cycle

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4. Effects of Business Cycles

5. Theories of Business Cycles

Hawtrey’s Monetary Theory

Hayek’s Monetary Over-Investment Theory

Schumpeter’s Innovations Theory

The Psychological Theory

The Cobweb Theory

Samuelson’s Model of business Cycle

Hicks’s Theory of the Business Cycle

6. Measures to Control Business Cycles or Stabilisation Policies

Monetary policy

Fiscal policy

Direct Controls

1. Meaning

Business cycle or trade cycle is a part of the capitalist system. It refers to the phenomenon of cyclical booms and depressions. In a business cycle, there are wave-like fluctuations in aggregate employment, income, output and price level. The term business cycle has been defined in various ways by different economists.

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Prof. Haberler’s definition is very simple: “The business cycle in the general sense may be defined as an alternation of periods of prosperity and depression of good and bad trade,” Keynes’ definition in his Treatise of Money is more explicit: “A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentage, altering with periods of bad trade characterised by falling prices and high unemployment percentages.”

Gordon’s definition is precise: “Business cycles consist of recurring alternation of expansion and contraction in aggregate economic activity, the alternating movements in each direction being self-reinforcing and pervading virtually, all parts of the economy.”

The most acceptable definition is by Estey: “Cyclical fluctuations are characterised by alternating waves of expansion and contraction. They do not have a fixed rhythm, but they are cycles in that the phases of contraction and expansion recur frequently and in fairly similar patterns.”

2. Characteristics of Business Cycles:

Business cycles possess the following characteristics:

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1. Cyclical fluctuations are wave-like movements.

2. Fluctuations are recurrent in nature.

3. They are non-periodic or irregular. In other words, the peaks and troughs do not occur at regular intervals.

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4. They occur in such aggregate variables as output, income, employment and prices.

5. These variables move at about the same time in the same direction but at different rates.

6. The durable goods industries experience relatively wide fluctuations in output and employment but relatively small fluctuations in prices. On the other hand, nondurable goods industries experience relatively wide fluctuations in prices but relatively small fluctuations in output and employment.

7. Business cycles are not seasonal fluctuations such as upswings in retail trade during Diwali or Christmas.

8. They are not secular trends such as long-run growth or decline in economic activity.

3. Phases of a Business Cycle

A typical cycle is generally divided into four phases:

(1) Expansion or prosperity or the upswing;

(2) recession or upper-turning point;

(3) contraction or depression or downswing; and

(4) revival or recovery or lower-turning point. These phases are recurrent and uniform in the case of different cycles. But no phase has defi­nite periodicity or time interval. As pointed out by Pigou, cycles may not be twins but they are of the same family.

Like families they have common characteristics that are capable of description. Starting at the trough or low point, a cycle passes through a recovery and prosperity phase, rises to a peak, declines through a recession and depression phase and reaches a trough. This is shown in Figure 1 where E is the equilibrium position. We de­scribe below these characteristics of a busi­ness cycle.

Recovery:

We start from a situation when depression has lasted for some time and the revival phase or the lower-turning point starts. The “originating forces” or “starters” may be exogenous or endogenous forces. Suppose the semi-durable goods wear out which necessitate their replacement in the economy. It leads to increased demand.

To meet this increased demand, investment and employment increase. Industry begins to revive. Revival also starts in related capital goods industries. Once begun, the process of revival becomes cumulative. As a result, the levels of employment, income and output rise steadily in the economy.

In the early stages of the revival phase, there is considerable excess or idle capacity in the economy so that output increases without a proportionate increase in total costs. But as time goes on, output becomes less elastic; bottlenecks appear with rising costs, deliveries are more difficult and plants may have to be expanded. Under these conditions, prices rise.

Profits increase. Business expectations improve. Optimism prevails. Investment is encouraged which tends to raise the demand for bank loans. It leads* to credit expansion. Thus the cumulative process of increase in investment, employment, output, income and prices feeds upon itself and becomes self-reinforcing.

Prosperity:

In the prosperity phase, demand, output, employment and income are at a high level. They tend to raise prices. But wages, salaries, interest rates, rentals and taxes do not rise in proportion to the rise in prices. The gap between prices and costs increases the margin of profit.

The increase of profit and the prospect of its continuance commonly cause a rapid rise in stock market values. The economy is engulfed in waves of optimism. Larger profit expectations further increase investment which is helped by liberal bank credit. Such investments are mostly in fixed capital, plant, equipment and machinery.

They lead to considerable expansion in economic activity by increasing the demand for consumer goods and further raising the price level. This encourages retailers, wholesalers and manufacturers to add to inventories. In this way, the expansionary process becomes cumulative and self-reinforcing until the economy reaches a very high level of production, known as the peak or boom.

The peak or prosperity may lead the economy to over full employment and to inflationary rise in prices. It is a symptom of the end of the prosperity phase and the beginning of the recession. The seeds of recession are contained in the boom in the form of strains in the economic structure which act as brakes to the expansionary path.

They are:

(i) scarcities of labour, raw materials, etc. leading to rise in costs relative to prices;

(ii) rise in the rate of interest due to scarcity of capital; and

(iii) failure of consumption to rise due to rising prices and stable propensity’ to consume when incomes increase. The first factor brings a decline in profit margins.

The second makes investments costly and along with the first, lowers business expectations. The third factor leads to the piling up of inventories indicating that sales (or consumption) lag behind production. These forces become cumulative and self-reinforcing. Entrepreneurs, businessmen and traders become over cautious and over optimism give way to pessi­mism. This is the beginning of the upper turning point.

Recession:

Recession starts when there is a downward descend from the ‘peak’ which is of a short duration. It marks the turning period during which the forces that make for contraction finally win over the forces of expansion. Its outward signs are liquidation in the stock market, strain in the banking system and some liquidation of bank loans, and the beginning of the decline of prices.

As a result, profit margins decline further because costs start overtaking prices. Some firms close down. Others reduce produc­tion and try to sell out accumulated stocks. Investment, employment, income and demand decline. This process becomes cumulative.

Recession may be mild or severe. The latter might lead to a sudden explosive situation emanating from the banking system or the stock exchange, and a panic or crisis occurs. “When a crisis, and more particularly a panic, does occur, it seems to be associated with a collapse of confidence and sudden demands for liquidity.

This crisis of nerves may itself be occasioned by some spectacular and unex­pected failure. A firm or a bank, or a corporation announces its inability to meet its debts. This announcement weakens other firms and banks at a time when ominous signs of distress are appearing in the economic structure; moreover, it sets off a wave of fright that culminates in a general run on financial institutions. Such was the experience of the United States in 1873, in 1893 and in 1907.” In the words of M. W. Lee, “A recession, once started, tends to build upon itself much as forest fire, once under way, tends to create its own draft and give internal impetus to its destructive ability.”

Depression:

Recession merges into depression when there is a general decline in economic activity. There is considerable reduction in the production of goods and services, employment, income, demand and prices. The general decline in economic activity leads to a fall in bank deposits. Credit expansion stops because the business community is not willing to borrow. Bank rate falls considerably.

According to Professor Estey, “This fall in active purchasing power is the fundamental background of the fall in prices that despite the general reduction of output, characterises the depression.” Thus a depression is characterised by mass unemployment; general fall in prices, profits, wages, interest rate, consumption, expenditure, investment, bank deposits and loans; factories close down; and construction of all types of capital goods, buildings, etc. comes to a standstill. These forces are cumulative and self-reinforcing and the economy is at the trough.

The trough or depression may be short-lived or it may continue at the bottom for considerable time. But sooner or later limiting forces are set in motion which ultimately tends to bring the contraction phase to end and pave the way for the revival. A cycle is thus complete.

4. Effects of Business Cycles

Business cycles have both good and bad effects depending upon whether the economy is passing through a phase of prosperity or depression. In the prosperity phase, “the real income consumed, real income produced and the level of em­ployment are high or rising and there are no idle or unemployed workers or very few of either.”

There is general increase in economic activity: aggregate output, demand, employment and income are at a high level. Prices are rising. Profits are increasing. Stock markets are rapidly reaching new heights. Investments are increasing with liberal bank credit. This entire process is cumulative and self-reinforc­ing.

But different sections of the society are affected differently during the prosperity phase. The landless, factory and agricultural workers and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities rise continuously. They become more poor. On the other hand, businessmen, traders, industrialists, real estate holders, speculators, landlords, shareholders and others with variable incomes gain. Thus the rich become richer and the poor poorer.

The social effects are also bad. Lured by profit, there is hoarding, black-marketing, adulteration, production of substandard goods, speculation, etc. Corruption spreads in every walk of life.

When the economy is nearing the full employment level of resources, the ill-effects on production start appearing. Rising prices of raw materials and increase in wages raise costs of production. As a result, profit margins decline. There is rise in interest rates due to scarcity of capital which makes investment costly.

These two factors lower business expectations. Lastly, the demand for consumer goods does not rise due to inflationary rise in prices. This leads to piling up of inventories (stocks) with producers and traders. Thus sales lag behind production. There is decline in prices. Producers, businessmen and traders become pessimists and the recession starts.

During recession, profit margins decline further because costs start rising more than prices. Some firms close down. Others reduce production and try to sell accumulated stocks. Investment, output, employment, income, demand and prices decline further. This process becomes cumulative and reces­sion merges into depression.

During a depression, there is mass unemployment. Prices, profits and wages are at their lowest levels. Demand for goods and services are the minimum. Investment, bank deposits and bank loans are negligible. Construction of all types of capital goods, buildings, etc. is at a standstill. There is mass unemployment in the economy. The government revenues from direct and indirect taxes decline. The real burden of the debt increases. The economic development of the country suffers.

5. Theories of Business Cycles

In fact, the causes of business cycles given above are based on the theories of business cycles propounded by economists from time to time.

We discuss some of the important theories as under:

1. Hawtrey’s Monetary Theory

According to Prof. R.G. Hawtrey, “The trade cycle is a purely monetary phenomenon.” It is changes in the flow of monetary demand on the part of businessmen that lead to prosperity and depres­sion in the economy. He opines that non-monetary factors like strikes, floods, earthquakes, droughts, wars, etc. may at best cause a partial depression, but not a general depression. In actuality, cyclical fluctuations are caused by expansion and contraction of bank credit which, in turn, lead to variations in the flow of monetary demand on the part of producers and traders.

Bank credit is the principal means of payment in the present times. Credit is expanded or reduced by the banking system by lowering or raising the rate of interest or by purchasing or selling securities to merchants. This increases or de­creases the flow of money in the economy and thus brings about prosperity or depression.

The expansion phase of the trade cycle starts when banks increase credit facilities. They are provided by reducing the lending rate of interest and by purchasing securities. These encourage bor­rowings on the part of merchants and producers. This is because they are very sensitive to changes in the rate of interest. So when credit becomes cheap, they borrow from banks in order to increase their stocks or inventories.

For this, they place larger orders with producers who, in turn, employ more factors of production to meet the increasing demand. Consequently, money incomes of the owners of factors of production increase, thereby increasing expenditure on goods. The merchants find their stocks being exhausted. They place more orders with producers.

This leads to further increase in productive activity, income, outlay, and demand, and a further depletion of stocks of merchants. Ac­cording to Hawtrey, “Increased activity means increased demand, and increased demand means in­creased activity. A vicious circle is set up, a cumulative expansion of productive activity.”

As the cumulative process of expansion continues, producers quote higher and higher prices. Higher prices induce traders to borrow more in order to hold still larger stocks of goods so as to earn more profits. Thus optimism encourages borrowing, borrowing increases sales, and sales raise opti­mism.

According to Hawtrey, prosperity cannot continue limitlessly, It comes to an end when bank stop credit expansion. Banks refuse to lend further because their cash funds are depleted and the money in circulation is absorbed in the form of cash holdings by consumers. Another factor is the export of gold to other countries when imports exceed exports as a result of high prices of domestic goods. These factors force the banks to raise interest rates and refuse to lend. Rather, they ask the business community to repay their loans. This starts the recessionary phase.

In order to repay bank loans, businessmen start selling their stocks. This sets the process of falling prices. They also cancel orders with producers. The latter curtail their productive activities due to fall in demand. These, in turn, lead to reduction in the demand for factors of production.

There is unemployment. Incomes fall. Falling demand, prices and incomes are the signals for depression. Unable to repay bank loans, some firms go into liquidation, thus forcing banks to contract credit further. Thus the entire process becomes cumulative and the economy is forced into depression.

According to Hawtrey, the process of recovery is very slow and halting. As depression contin­ues, traders repay bank loans by selling their stocks at whatever prices they can. As a result, money flows into the reserves of banks and funds increase with banks. Even though the bank rate is very low, there is “credit deadlock” which prevents businessmen to borrow from banks due to pessimism in economic activity. This deadlock can be broken by following a cheap money policy by the central bank which will ultimately bring about recovery in the economy.

It’s Criticisms:

Monetarists like Friedman have supported Hawtrey’s theory. But the majority of economists have criticised him for over-emphasising monetary factors to the neglect of non-monetary factors in explain­ing cyclical fluctuations.

Some of the points of criticism are discussed below:

(1) Credit not the Cause of Cycle:

None can deny that expansion of credit leads to the expan­sion of business activity. But Hawtrey believes that an expansion of credit leads to a boom. This is not correct because the former is mu the cause of the latter. As pointed out by Pigou, “Variations in the bank money supply is a part of the business cycle, it is not the cause of it.”

At the bottom of the depression, credit is easily available. Even then, it fails to bring a revival. Similarly, contraction of credit cannot bring about a depression. At best, it can create conditions for that. Thus expansion or contrac­tion of credit cannot originate either boom or depression in the economy.

(2) Money Supply cannot continue a Boom or Delay a Depression:

Haberler has criticised Hawtrey for “his contention that the reason for the breakdown of the boom is always a monetary one and that prosperity could be prolonged and depression stayed off indefinitely if the money supply were inexhaustible.” But the fact is that even if the supply of money is inexhaustible in the country, neither prosperity can be continued indefinitely nor depression can be delayed indefinitely.

(3) Traders do not depend Only on Bank Credit:

Hamberghas criticised Hawtrey for the role assigned to wholesalers in his analysis. The kingpin in Hawtrey’s theory is the trader or the wholesaler who gets credit from banks and starts the upturn or vice-versa. In actuality, traders do not depend exclusively on bank credit but they finance business through their own accumulated funds and borrow­ing from private sources.

(4) Traders do not react to changes in Interest Rates:

Further, Hamberg also does not agree with Hawtrey that traders react to changes in interest rates. According to Hamberg, traders are likely to react favourably to a reduction in the interest rate only if they think that the reduction is permanent. But they do not react favourably during the depression phase because traders expect a further reduction every time the interest rate is reduced. On the other hand, if traders finance their stocks with their own funds, interest rate changes will have little effect on their purchases.

(5) Factors other than Interest Rate More Important:

It is an exaggeration to say that the decisions of traders regarding accumulation or depletion of stocks are solely governed by changes in interest rate. As a matter of fact, factors other than the rate of interest are more important in influencing such decisions. They are business expectations, price changes, cost of storage, etc.

(6) Inventory Investments do not Produce True Cycles:

Hamberg further points out that in Hawtrey’s theory cumulative movements in economic activity are the results of changes in stocks of goods. But fluctuations in inventory investment can at best produce minor cycles which are not cycles in the true sense of the term.

(7) Does not explain Periodicity of Cycle:

The theory also fails to explain the periodicity of the cycle.

(8) Ignores Non-Monetary Factors:

Hawtrey’s theory is incomplete because it emphasises only monetary factors and totally ignores such non-monetary factors as innovations, capital stock, multiplier-accelerator interaction, etc.

2. Hayek’s Monetary Over-Investment Theory:

F. A. Hayek formulated his monetary over-investment theory of trade cycle. He explained his theory on the basis of Wicksell’s distinction between the natural interest rate and the market interest rate. The natural rate of interest is that rate at which the demand for loanable funds equals the supply of voluntary savings. On the other hand, the market rate of interest is the money rate which prevails in the market and is determined by the demand and supply of money.

According to Hayek, so long as the natural rate of interest equals the market rate of interest, the economy remains in the state of equilibrium and full employment. Trade cycles in the economy are caused by inequality between market and natural interest rates. When the market interest rate is less than the natural rate, there is prosperity in the economy. On the contrary, when the market interest rate is more than the natural rate, the economy is in depression.

According to this theory, prosperity begins when the market rate of interest is less than the natural rate of interest. In such a situation, the demand for investment funds is more than the supply of available savings. The demand for investment funds is met by the increase in the supply of money. As a result, the interest rate falls. Low interest rate induces producers to get more loans from banks.

The producers get more loans to invest for the production of more capital goods. They adopt capital- intensive methods for producing more of capital goods. As a result, production costs fall and profits increase. The production process becomes very lengthy with the adoption of capital-intensive methods. This has the effect of increasing the prices of capital goods in comparison to consumer goods.

There being full employment in the economy, they transfer factors of the production from consumer goods sector to capital goods sector. Consequently, the production of consumer goods falls, their prices increase and their consumption decreases. Forced savings increase with the fall in consumption which is invested for the production of capital goods. This leads to increase in their production. On the other hand, with increase in the prices of consumer goods, their producers earn more profits. Induced by high profits, they try to produce more.

For this, they pay higher remuneration to factors of production in comparison with the producers of capital goods. There being competition between the two sectors, prices of factors and prices in the economy continue to rise. This leads to the atmosphere of prosperity in the country and monetary over-investment on factors spreads the boom.

According to Hayek, when the prices of factors are rising continuously, the rise in production costs bring fall in profits of producers. The producers of capital goods invest less in the expectation of loss in the future. Consequently, the natural interest rate falls. Simultaneously, banks impose restrictions on giving loans to them.

With low profits and reduction in loans, producers reduce the production of capital goods and adopt labour-intensive production processes. There is less investment in capital goods. Production process beir0 small and labour intensive, the demand for money is reduced, which increases the market interest rate which to more than the natural interest rate.

Producers transfer the factors from the production of capital goods to that of consumer goods. But more factors cannot be used in the consumer goods sector as compared to the capital goods sector. This leads to fall in the prices of factors and resources become unemployed. Thus, with the continuous reduction in the prices of goods and factors in the economy, a long period of depression and unemployment begins.

According to Hayek, when the fall in p- ices comes to an end during depression, banks begin to raise the supply of money which reduces the market interest rate below the natural interest rate. This encourages investment and the process of revival begins in the economy.

Criticisms:

The monetary over-investment theory of Hayek has been criticised on the following counts:

(1) Narrow Assumption of Full Employment:

This theory is based on the assumption of full employment according to which capital goods are produced by reducing consumer goods. In reality, there is no full employment of resources. If resources remain unutilised, the expansion of both the capital goods sector and consumer goods sector may occur simultaneously. In such a situation, there is no need of transferring resources from one sector to the other.

(2) Unrealistic Assumption of Equilibrium:

The assumption of this theory that in the begin­ning savings and investment are in equilibrium in the economy and the banking system destroys this equilibrium is unrealistic. This is because the equilibrium may deviate due to both internal and external reasons.

(3) Interest Rate not the only Determinant:

Hayek assumes changes in the rate of interest as the cause of fluctuations in the economy. This is not correct because besides changes in the rate of interest, the expectations of profit, innovation, invention, etc. also affect trade cycles.

(4) Undue Importance to Forced Savings:

Prof. Strigl has criticised this theory for giving undue importance to forced savings. According to him, when people with fixed incomes reduce their consumption with the increase in prices and the high income groups also reduce their consumption to the same extent, savings will not be forced but voluntary.

(5) Investment does not fall with Increase in Consumer Goods:

Hayek argues that with the production of consumer goods and the increase in profits from them, investment falls in capital goods.

This is not correct. According to Keynes, the marginal productivity of capital increases with the increase in profits of consumer goods. As a result, investment in capital goods also increases and does not fall.

(6) Incomplete Theory:

Hayek’s theory is incomplete because it does not explain the various phases of trade cycle.

3. Schumpeter’s Innovations Theory:

The innovations theory of trade cycles is associated with the name of Joseph Schumpeter. Ac­cording to Schumpeter, innovations in the structure of an economy are the source of economic fluctua­tions. Trade cycles are the outcome of economic development in a capitalist society. Schumpeter accepts Juglar’s statement that “the cause of depression is prosperity,” and then gives his own view about the originating cause of the cycle.

Schumpeter’s approach involves the development of his model into two stages. The first stage deals with the initial impact of innovation and the second stage follows through reactions to the original impact of innovation.

The first approximation starts with the economic system in equilibrium with every factor fully employed. Every firm is in equilibrium and producing efficiently with its costs equal to its receipts. Product prices are equal to both average and marginal costs. Profits and interest rates are zero. There are no savings and investments.

This equilibrium is characterised by Schumpeter as the “circular flow” which continues to repeat itself in the same manner year after year, similar to the circulation of the blood in an animal organism. In the circular flow, the same products are produced every year in the same manner.

Schumpeter’s theory starts with the breaking up of the circular flow by an innovation in the form of a new product by an entrepreneur for earning profit.

By innovation Schumpeter means “such changes in the production of goods as cannot be affected by infinitesimal steps or variations on the margin.”

An innovation may consist of:

(1) The introduction of a new product;

(2) The introduction of a new method of production;

(3) The opening up of a new market;

(4) The conquest of a new source of raw materials or semi-manufactured goods; and

(5) The carrying out of the new organisations of an industry.

Innovations are not inventions. According to Schumpeter, there is nothing that can explain that inventions occur in a cyclical manner. It is the introduction of a new product and the continual improvements in the existing ones that are the principal causes of business cycles.

Schumpeter assigns the role of an innovator net to the capitalist but to an entrepreneur. The entrepreneur is not a man of ordinary ability but one who introduces something entirely new. He does not provide funds but directs their use.

To perform his economic function, the entrepreneur requires two things: first, the existence of technical knowledge in order to produce new products, and second, and the power of disposal over the factors of production in the form of bank credit. According to Schumpeter, a reservoir of untapped technical knowledge exists in a capitalist society which he can make use of. Therefore, credit is essential for breaking the circular flow.

The innovating entrepreneur is financed by expansion of bank credit. Since investment in an innovation is risky, he must pay interest on it. With his newly acquired funds, the innovator starts bidding away resources from other industries. Money incomes increase. Prices begin to rise, thereby stimulating further investment.

The new innovation starts producing goods and there is an increased flow of goods in the economy. Consequently, supply exceeds demand. Prices and cost of production of goods start declining until recession sets in. Because of the low prices of goods, producers are not willing to expand production. During this period of recession, credit, prices and interest rate decline but total output is likely to average larger than in the preceding prosperity.

Thus Schumpeter’s first approximation consists of a two-phase cycle. The economy starts at the equilibrium state, rises to a peak and then starts downward into a recession and continues till the new equilibrium is reached. This new equilibrium will be at a higher level of income than the initial equilib­rium because of the innovation which started the cycle. This is shown as the “Primary Wave” in Figure 2.

The second approximation of Schumpeter follows through the reaction of the impact of original innovation. Once the original innovation becomes successful and profitable, other entrepreneurs follow it in “swarm-like clusters.” Innovation in one field induces innovations in related fields.

Consequently, money incomes and prices rise and help to create a cumulative expansion throughout the economy. With the increase in the purchasing power of consumers, the demand for the products of old industries in- creases in relation to supply. Prices rise further. Profits increase and old industries expand by borrowing from the banks.

It in­duces a secondary’ wave of credit inflation which is superimposed on the primary wave of innovation. Over optimism and speculation add further to the boom. After a period of о gestation, the new products start appearing in the market displacing the old products and en­forcing a process of liquidation, readjustment and absorption.

The demand for the old products is decreased. Their prices fall. The old firms contract output and some are even forced to run into liquidation. As the innovators start repaying bank loans out of profits, the quantity of money is decreased and prices tend to fall. Profits decline. Uncertainty and risks increase. The impulse for innovation is reduced and eventually comes to an end. Depression sets in, and the painful process of readjustment to the “point of previous neighbourhood of equilibrium” begins. Ultimately, the natural forces of recovery bring about a revival.

Schumpeter believes in the existence of Kondratieff long wave of upswings and downswings in economic activity. Each long wave upswing is brought about by an innovation which leads to abun­dance of goods for the masses. Once the upswing ends, the long wave downswing begins.

Thus the second approximation of Schumpeter’s theory of trade cycle develops into a four phase cycle with the recession which was the second phase in the first approximation continuing downward to give the depression phase. This extension of cycle is followed by a period of revival which continues till the equilibrium level is reached. This is shown as the “Secondary Wave” in Figure 2.

It’s Criticisms:

Schumpeter’s treatment of the different phases and turning points of the cycle is novel and differ­ent from all other economists. But it is not free from certain criticisms.

(1) Innovator not Necessary for Innovations:

Schumpeter’s analysis is based on the innovator. Such persons were to be found in the 18th and 19th centuries that made innovations. But now all innovations form part of the functions of joint stock companies. Innovations are regarded as the routine of industrial concerns and do not require an innovator as such.

(2) Innovations not the Only Cause of Cycles:

Schumpeter’s contention that cyclical fluctua­tions are due to innovations is not correct. As a matter of fact, trade cycles may be due to psychologi­cal, natural or financial causes.

(3) Bank Credit not the Only Source of Funds:

Schumpeter gives too much importance to bank credit in his theory. Bank credit may be important in the short run when industrial concerns get credit facilities from banks. But in the long run when the need for capital funds is much greater, bank credit is insufficient. For this, business houses have to float fresh shares and debentures in the capital market. Schumpeter’s theory is weak in that it does not take these factors into consideration.

(4) Innovation financed through Voluntary Savings does not produce a Cycle:

Critics point out that if an innovation is financed through voluntary savings or internal funds, there will not be an inflationary rise in prices. Consequently, in an underemployed economy an innovation financed through voluntary savings might not generate a cycle.

(5) Full Employment Assumption Unrealistic:

Schumpeter’s analysis is based on the unrealistic assumption of full employment of resources to begin with. But the fact is that at the time of revival, the resources are unemployed. Thus the introduction of an innovation may not lead to the withdrawal of labour and other resources from old industries. Thus the competitive impact of an innovation would not increase costs and prices. Since full employment is an exception rather than the rule. Thus Schumpeter’s theory is not a correct explanation of trade cycles.

4. The Psychological Theory:

The psychological theory of business cycle has been mainly developed by Prof. A.C. Pigou. This theory attempts to explain the phenomenon of business cycle on the basis of changes in the psychology of industrialists and businessmen. The tendency of the business class is to react excessively to the changing conditions of the economy that are mainly responsible for cyclical fluctuations. According to Pigou, expectations originate from some real factors such as good harvests, wars, natural calamities, industrial disputes, innovations, etc.

But he attributes the causes of business cycle into two categories:

(a) Impulses and

(b) conditions.

Impulses refer to those causes which set a process in motion. The conditions, on the other hand, are the vehicles through which the process passes and upon which the impulses act. These conditions are the decision making centres which, in turn, shift the levels of economic activities and bring necessary changes in their compositions. They include monetary institutions, market structures, trade unions, etc.

Pigou divides impulses into two parts:

(i) The expectations held by businessmen, and

(ii) The actual economic resources owned by them.

The expectations depend upon the psychology of business­men and on their control over resources. But expectations which correspond to actual changes in the economy and are realised, they do not generate cyclical fluctuations.

According to Pigou, it is only when expectations are devoid of their realistic basis there may be error in forecasting. Such type of expectations cause disturbances in the economy and result in waves of optimism and pessimism.

Such “errors in forecasting” may be due to:

(i) The deviation of actual demand from anticipated demand on the part of consumers;

(ii) The continual and unpredictable change in the values of economic variables, and

(iii) The existence of time lags on account of gestation periods.

Once an error of forecasting occurs in any sector of the economy, it spreads in the same direc­tions. Once this “impulse” starts acting on the “conditions”, it feeds upon itself. According to Pigou, this is because there is a certain measure of psychological interdependence. In other words, the expectations of optimism or pessimism on the part of businessmen strengthen the building up of further expectations of the same type.

When businessmen have a feeling of optimism about the future prospects of business, it would increase the demand for investment resources and inter-industry relations would induce busi­nessmen in other industries to be optimist. Consequently, there is the emergence of boom conditions in the economy.

Pigou opines that the wave of optimism is replaced by pessimism on account of time lags in production. Being over optimistic, some producers make the mistake of over investing in goods. When the goods start coming into the market in large quantities, it is not possible to sell them at remunerative prices. As a result, inventories accumulate.

A wave of pessimism starts which spreads to other sectors of the economy. This leads to the emergence of slump in the country. To Pigou, the lower turning point starts when inventories are depleted and the “bolder spirit of industry” helps to revive expectations. As a result, the rays of optimism spread slowly and revival starts which leads to boom and so on.

Thus according to this theory, booms and slumps are due to alternative waves of optimism and pessimism on the part of businessmen and industrialists.

It’s Criticism:

The psychology theory has been criticised for the following reasons:

1. This is not a theory of business cycles in the true sense because it fails to explain the different phases of a business cycle.

2. It fails to explain the periodicity of a business cycle.

3. It neglects the role of various exogenous and monetary factors which influence business expec­tations.

4. The theory does not explain fully the causes that give rise ‘to waves of optimism and pessi­mism’ in the business world.

5. The theory fails to explain the reason for deficiency of demand when goods start entering the market in larger quantities. Moreover, it does not explain as to why the deficiency of demand overtakes the flow of goods in the market.

5. The Cobweb Theory:

The cobweb theory of business cycles was propounded in 1930 independently by Professors H. Schultz of America, J. Tinbergen of the Netherlands and U. Ricci of Italy. But it was Prof. N. Kaldor of Cambridge University, England, who used the name Cobweb Theorem because the pattern of move­ments of prices and outputs resembled a cobweb.

The cobweb model is used to explain the dynamics of demand, supply and price over long periods of time. There are many perishable agricultural commodities whose prices and outputs are determined over long periods and they show cyclical movements. As prices move up and down in cycles, quantities produced also seem to move up and down in a counter-cyclical manner. Such cycles in commodity prices and outputs are explained in terms of the cobweb model, so called because the diagrams look like cobwebs.

Suppose the production process spreads over two periods: current and previous. Production in the current period is assumed to be determined by decisions made in the previous period. Thus the current output reflects a production decision made by the producer during the previous period. This decision is in response to the price that he expects to rule during the current period when the crop is available for sale. But he expects that the price that would be established during the current period would equal the price during the previous period.

The cobweb theory analyses the movements of prices and outputs when supply is wholly deter­mined by prices in the previous period. In order to find out the conditions for converging, diverging or constant cycles, one has to look first at the slope of the demand curve and then of the supply curve.

If the slope of the demand curve is numerically smaller than the slope of the supply curve, the price will converge towards equilibrium. Conversely, if the slope of the demand curve is numerically greater than the slope of supply curve, the price will diverge from equilibrium. If the slope of the demand curve is numerically the same as that of the supply curve, the price will oscillate around its equilibrium value.

It’s Assumptions:

The cobweb theory is based on the following assumptions:

(1) The current year’s (t) supply depends upon the last (previous) year’s (t-1) decisions regarding output level. Hence current output is influenced by last year’s price, i.e. P (t-1).

(2) The current period or year is divided into sub-periods of a week or fortnight.

(3) The parameters determining the supply function have constant values over a series of periods.

(4) Current demand (Dt) for the commodity is a function of current price (P1).

(5) The price expected to rule in the current period is the actual price in the last year.

(6) The commodity under consideration is perishable and can be stored only for one year.

(7) Both supply and demand functions are linear.

The Theory:

There are three types of cobwebs:

(1) Convergent;

(2) Divergent; and

(3) Continuous.

They are explained as under:

1. Convergent Cobweb:

Under this formulation of the cobweb theorem, the supply function is S1 = S (t-1) and the demand function is Dt = D (P t). The market equilibrium will be when the quantity supplied equals the quantity demanded. St = Dt in any market in which producers’ current supply is in response to the price during the last year, equilibrium can be estab­lished only through a series of adjustments that take place over several consecutive periods.

Let us take potato growers who produce only one crop a year. They decide about how many potatoes they will grow this year on the assumption that the price of potatoes this year will equal the price in the last year. The market demand and supply curves for potatoes are repre­sented by D and S curves respectively in Figure 3. The price in the last year was OP and the producers decide the equilibrium output OQ this year.

But the potato crop is damaged due to blight so that their current output is OQ1 which is smaller than the equilibrium output OQ. This leads to rise in the price to OP1 in the current period. In the next period, the potato growers will produce ОО1 quantity in response to the higher price OP 1(=Q1 b).

But this is more than the equilibrium quantity OQ which is needed in the market. It will, therefore, lower the price to ОР2 (=Q1d) and thus again lead to changes in the production plans of producers whereby they will reduce supply to OQ3 in the third period. But this quantity is less than the equilibrium quantity OQ. Price will, therefore, rise to OP3 (=Q3 f) which, in turn, will encourage producers to produce OQ quantity.

Ultimately, the equilibrium will be established at point g where D and S curves intersect. The series of adjustments just described trace out a cobweb pattern a, b, c, d, e and f which converge towards the point of market equilibrium g when period-to-period changes in price and quantity have been reduced to zero. The cobweb is convergent.

(2) Divergent Cobweb:

But there may be an unstable cobweb when price and quantity changes move away from the equilibrium position. This is illustrated in Figure 4. Suppose from the initial price- quantity equilibrium situation of OP and OQ, there is a temporary disturbance that causes output to fall to OQ1.This raises the price to OP1 (=Q1a). The in­creased price, in turn, raises output to OQ2 which is more than the equilibrium output OQ. Consequently, the price falls to OP2. But at this price the demand (OQ2) exceeds the supply (OQ3). As a result, the price shoots up to OP3 (=Q3e) and the adjustment of pro­ducers to this price leads farther away from the equi­librium. This is an explosive situation and the equilibrium position is unstable. The cobweb is divergent.

(3) Continuous Cobweb:

]The cobweb may be of constant amplitude with perpetually oscillating prices and quantities, as shown in Figure 5. Suppose that the price in the current year is OP. Thus the quantity to be supplied is going to be OQ1 .But in order to sell this output, the price that it will fetch in the next period will be OPv .But at this price, the demand OQ1 is more than the supply OQ which will again raise the price to OP (=Qb). In this way, prices and quantities will move in a circle with oscillations of constant amplitude around the equilibrium point e.

Its Criticisms:

The analysis of the cobweb theory is based upon very restrictive assumptions which make its applicability doubtful.

1. Not Realistic:

It is not realistic to assume that the demand and supply conditions remain unchanged over the previous and current periods so that the demand and supply curves do not change (or shift). In reality, they are bound to change with considerable divergences between the actual and expected prices. Suppose the price is so low that some producers incur heavy losses.

As a result, the number of sellers is reduced which changes the position of the supply curve. It is also possible that the expected price may be quite different from the estimated price. As a result, the cobweb may not develop properly on the basis of unchanged demand and supply curves. Thus demand, supply and price relations that lead to different cobwebs have little real applicability.

2. Output not Determined by Price:

The theory assumes that the output is determined by the price only. In reality, the agricultural output in particular is determined by several other factors also, such as weather, seeds, fertilizer, technology, etc.

3. Divergent Cobweb Impossible:

Critics hold that divergent cobweb is impossible. It is obvious from Fig. 4 that once the equilibrium is upset, the cobweb cycle goes on diverging for an indefinite period which leads to an explosive situation. It is impossible.

4. Continuous Cobweb Impractical:

Critics point out that continuous cobweb is impractical because it cannot continue indefinitely. This is because producers incur more loss than profit from it. This is explained by Fig. 5. If a fanner produces OQ output, he receives total revenue OQbP whereas his total cost is OQaP1and his net profit is PbaP1. When the output is OQ1, total revenue is OQ1dP1while the total cost is OQ1cP. Thus, he incurs P1dcP total loss. Hence, in the case of continuous cobweb cycle, the producers have to face alternative years of profit and loss, but losses always exceed profit. Therefore, this cycle is impractical.

5. Not a Theory:

In reality, cobweb is not a business cycle theory because it only explains fluctuations in the agricultural sector. So it is not used in explaining business cycles.

It’s Implications:

The cobweb model is an oversimplification of the real price determination process. But it supplies new information to the market participants about the market behaviour which they can incorporate into their decisions. The cobweb model is not merely an adjustment process of the market equilibrium but it also predicts unobservable events. Its significance lies in the demand, supply and price behaviour of agricultural commodities.

Expectations about future conditions have an important influence on current prices. If there are boom conditions in the country, the farmers expect higher prices of their crops and increase their supplies in the market. But in the event of crop failures, the supplies of agricultural commodities will be reduced. In such a situation, the government may exempt farmers from agricultural taxes and even provide interest free loans to tide over the crisis.

On the contrary, a bumper crop may lower the prices of agricultural crops by increasing their supplies more than their demand. In such a situation, the government may give subsidies to fanners or procure agricultural products at minimum support prices from the farmers.

6. Samuelson’s Model of business Cycle:

Prof. Samuelson constructed a multiplier-accelerator model assuming one period lag and differ­ent values for the MPC (α) and the accelerator (β) that result in changes in the level of income pertain­ing to five different types of fluctuations.

The Samuelson model is

Y t= Gt+ Ct+ It … (1)

where Yt is national income Y at time t which is the sum of government expenditure G1, consumption expenditure C1 and induced investment I1.

Ct= αYt-1 …(2)

It= β (Ct-C t-1) …(3)

Substituting equation (2) in (3) we have,

I= β (αYt-1 – αYt- 2)

It = βαYt-1 – βaYt- 2 …(4)

Gt = l …(5)

Substituting equations (2), (4) and (5) in (1) we have

Yt = 1+ aYt-1 + βαYt-1 – BαY t-2 …(6)

= 1+ a(1+ β)Yt-1,-βαY t-2

= 1+ a(1+ β) Yt-1=βaY(t- 20) …(7)

According to Samuelson, “If we know the national income for two periods, the national income for the following period can be simply derived by taking a weighted sum. The weights depend, of course, upon the values chosen for the marginal propensity to consume and for the relation (i.e. accelerator)”.

Assuming the value of the marginal propensity to consume to be greater than zero and less than one (β a <1) and of the accelerator greater than zero (P > 0), Samuelson explains five types of cyclical fluctuations which are summarised in the Table 1.

Table 1. Samuelson’s Interaction Model

Case

Values

Behaviour of the Cycle

1

a = .5, p = 0

Cycleless Path

2

a = .5, p = 1

Damped Fluctuations

3

a = .5, p = 2

Fluctuations of Constant Amplitude

4

a = .5, p = 3

Explosive Cycles

5

a = .5, p = 4

Cycleless Explosive Path

Case 1:

Samuelson’s case 1 shows a cycleless path because it is based only on the multiplier effect, the accelerator playing no part in it. This is shown in Fig. 6 (A).

Case 2:

Shows a damped cyclical path fluctuating around the static multiplier level and gradually subsiding to that level, as shown in Fig. 6 (B).

Case 3:

Depicts cycles of constant amplitude repeating themselves around the multiplier level. This case is depicted in Fig. 6 (C).

Case 4:

Reveals anti-damped or explosive cycles, see Fig. 6 (D).

Case 5:

Relates to a cycleless explosive upward path eventually approaching a compound interest rate of growth, as shown in Fig. 6 (E). Of the five cases explained above, only three cases 2, 3 and 4 are cyclical in nature. But they can be reduced to two because case 3 pertaining to cycles of constant amplitude has not been experienced.

So far as case 2 of damped cycles is concerned these cycles have been occurring irregularly in a milder form over last half century. Generally, cycles in the post-World War II period have been relatively damped compared to those in the inter-World War II period.

They are the result of “such distur­bances—which may be called erratic shocks—arising from exogenous factors, such as wars, changes in crops, inventions and so on ‘which’ might be expected to come along with fair persistence.” But it is not possible to measure their magnitude.

Case 6:

Of explosive cycles has not been found in the past, its absence being the result of endog­enous economic factors that limit the swings. Hicks has, however, built a model of the trade cycle assuming values that would make for explosive cycles kept in check by ceilings and floors.

Critical Appraisal of the Model:

The interaction of the multiplier and the accelerator has the merit of raising national income at a much faster rate than by either the multiplier or the accelerator alone. It serves as a useful tool not only for explaining business cycles but also as a guide to stabilisation policy. As pointed out by Prof. Kurihara, It is in conjunction with the multiplier analysis based on the concept of marginal propensity to Consume (being less than one) that the acceleration principle serves as a useful tool of business cycle analysis and a helpful guide to business cycle policy.” The multiplier and the accelerator combined together produce cyclical fluctuations. The greater the value of the accelerator (β), the greater is the chance of an explosive cycle.

The greater the value of the multiplier, the greater the chance of a cycleless path. We may conclude with Prof. Estey, “Thus the combination of the multiplier and the accelerator seems capable of producing cyclical fluctuations. The multiplier alone produces no cycles from any given impulse but only a gradual increase to a constant level of income determined by the propensity to consume.

But if the principle of acceleration is introduced, the result is a series of oscillations of about what might be called the multiplier level. The accelerator first carries total income above its level, but as the rate of increase of income diminishes, the accelerator introduces a downturn which carries total income below the multiplier level, then up again, and so on.”

It’s Limitations:

Despite these apparent uses of the multiplier-accelerator interaction, this analysis has its limita­tions:

(1) Samuelson is silent about the length of the period in the different cycles explained by him.

(2) This model assumes that the marginal propensity to consume (a) and the accelerator (P) are constants, but in reality they change with the level of income so that this is applicable only to the study of small fluctuations.

(3) The cycles explained in this model oscillate about a stationary level in a trendless economy. This is not realistic because an economy is not trendless but it is in a process of growth. This has led Hicks to formulate his theory of the trade cycle in a growing economy.

7. Hicks’s Theory of the Business Cycle:

J.R. Hicks in his book A Contribution to the Theory of the Trade Cycle builds his theory of business cycles around the principle of the multiplier-accelerator interaction. To him, “the theory of the acceleration and the theory of the multiplier are the two sides of the theory of fluctuations.” Unlike Samuelson’s model, it is concerned with the problem of growth and of a moving equilibrium.

The warranted rate of growth is the rate which will sustain itself. It is consistent with saving- investment equilibrium. The economy is said to be growing at the warranted rate when real investment and real saving are taking place at the same rate. According to Hicks, it is the multiplier-accelerator interaction which weaves the path of economic fluctuations around the warranted growth rate.

The consumption function takes the form Ct = a Y t-1,Consumption in period t is regarded as a function of income (Y) of the previous period (t-1). Thus consumption lags behind income, and the multiplier is treated as a lagged relation.

The autonomous investment is independent of changes in the level of output. Hence it is not related to the growth of the economy.

The induced investment, on the other hand, is dependent on changes in the level of output. Hence it is a function of the growth rate of the economy. In the Hicksian model, the accelerator is based on induced investment which alongwith the multiplier brings about an upturn. The accelerator is defined by Hicks as the ratio of induced investment to the increase in income. Given constant values of the multi­plier and the accelerator, it is the ‘leverage effect’ that is responsible for economic fluctuations.

Assumptions of the Model:

The Hicksian theory of trade cycle is based on the following assumptions:

(1) Hicks assume a progressive economy in which autonomous investment increases at a con­stant rate so that the system remains in a moving equilibrium.

(2) The saving and investment coefficients are disturbed overtime in such a way that an upward displacement from equilibrium path leads to a lagged movement away from equilibrium.

(3) Hicks assume constant values for the multiplier and the accelerator.

(4) The economy cannot expand beyond the full employment level of output. Thus “the full employment ceiling” acts as a direct restraint on the upward expansion of the economy.

(5) The working of the accelerator in the downswing provides an indirect restraint on the down­ward movement of the economy. The rate of decrease in the accelerator is limited by the rate of depreciation in the downswing.

(6) The relation between the multiplier and accelerator is treated in a lagged manner, since con­sumption and induced investment are assumed to operate with a time lag.

(7) It is assumed that the average capital-output ratio (v) is greater than unity and that gross investment does not fall below zero. Thus the cycles are inherently explosive but are contained by ceilings and floors of the economy.

The Hicksian Model:

Hicks explain his theory of the trade cycle in terms of Fig. 7. Line AA shows the path of autono­mous investment growing at a constant rate. EE is the equilibrium level of output which depends on AA and is deduced from it by the application of the multiplier accelerator interaction to it. Line FF is the full employment ceiling level above the equilibrium path EE and is growing at the constant rate of autono­mous investment. LL is the lower equilibrium path of output representing the floor or ‘slump equilibrium line’.

Hicks begin from a cycleless situation Po on the equilibrium path EE when an increase in the rate of autonomous investment leads to an upward movement in income. As a result, the growth of output and income propelled by the combined operation of the multiplier and accelerator moves the economy on to the upward expansion path from Po to P1.

According to Hicks, this upswing phase relates to the standard cycle which will lead to an explosive situation because of the given values of the multiplier and the accelerator. But this does not happen because of the upper limit or ceiling set by the full employment level FF. Hicks writes in this connection: “I shall follow Keynes in assuming that there is some point at which output becomes inelastic in response to an increase in effective demand.” Thus certain bottlenecks of supply emerge which prevent output from reaching the peak and instead encounter the ceiling at P1

When the economy hits the full employment ceiling at P1, it will creep along the ceiling for a period of time to P2 and the downward swing will not start immediately. The economy will move along the ceiling from P1 to depending upon the time period of the investment lag. The greater the investment lag, the more the economy will move along the ceiling path. Since income at this level is decreasing relative to the previous stage of the cycle, there is a decreased amount of investment. This much of investment is insufficient to keep the economy at the ceiling level, and then the downturn starts.

During the downswing, “the multiplier-accelerator mechanism sets in reverse, falling in­vestment reducing income, reduced income re­ducing investment, and so on, progressively. If the accelerator worked continuously, output would plunge downward below the equilibrium level EE, and because of explosive tendencies, to a greater extent than it rose above it.” The fall in output in this case might be a steep one, as shown by Р2 P3 Q. But in the downswing, the accelerator does not work so swiftly as in the upswing. If the slump is severe, induced investment will quickly fall to zero and the value of the accelerator becomes zero.

The rate of decrease in investment is limited by the rate of depreciation. Thus the total amount of investment in the economy is equal to autonomous investment minus the constant rate of depreciation. Since autonomous investment is taking place, the fall in output is much gradual and the slump much longer than the boom, as indicated by Q1Q2 .

At Q2 the slump reaches the bottom or floor provided by the LL line. The economy does not turn upward immediately from Q2 but will move along the slump equilibrium line to Q3 because of the existence of excess capacity in the economy. Finally, when all excess capacity is exhausted, autonomous investment will cause income to rise which will in turn lead to an increase in induced investment so that the accelerator is triggered off which alongwith the multiplier moves the economy toward the ceiling again. It is in this way that the cyclical process will be repeated in the economy.

It’s Criticisms:

The Hicksian theory of the business cycle has been severely criticised by Duesenberry, Smithies and others on the following grounds:

1. Value of Multiplier not Constant:

Hicks’s model assumes that the value of the multiplier remains constant during the different phases of the trade cycle. This is based on the Keynesian stable consumption function. But this is not a realistic assumption, as Friedman has proved on the basis of empirical evidence that the marginal propensity to consume does not remain stable in relation to cyclical changes in income. Thus the value of the multiplier changes with different phases of the cycle.

2. Value of Accelerator not Constant:

Hicks has also been criticised for assuming a constant value of the accelerator during the different phases of the cycle. The constancy of the accelerator presupposes a constant capital-output ratio. These are unrealistic assumptions because the capital- output ratio is itself subject to change due to technological factors, the nature and composition of investment, the gestation period of capital goods, etc. Lundberg, therefore, suggests that the assump­tion of constancy in accelerator should be abandoned for a realistic approach to the understanding of trade cycles.

3. Autonomous Investment not Continuous:

Hicks assume that autonomous investment continues throughout the different phases of the cycle at a steady pace. This is unrealistic because financial crisis in a slump may reduce autonomous investment below its normal level. Further, it is also possible, as pointed out by Schumpeter, that autonomous investment may itself be subject to fluctua­tions due to a technological innovation.

4. Growth not Dependent only on changes in Autonomous Investment:

Another weakness of the Hicksian model is that growth is made dependent upon changes in autonomous investment. It is a burst of autonomous investment from the equilibrium path that leads to growth. According to Prof. Smithies, the source of growth should lie within the system. In imputing growth to an unexplained extraneous factor, Hicks has failed to provide a complete explanation of the cycle.

5. Distinction between Autonomous and Induced Investment not Feasible:

Critics like Duesenberry and Lundberg point out that Hicks’s distinction between autonomous and induced invest­ment is not feasible in practice. As pointed out by Lundberg, every investment is autonomous in the short run and a major amount of autonomous investment becomes indeed in the long run. It is also possible that part of a particular investment may be autonomous and a part induced, as in the case of machinery. Hence this distinction between autonomous and induced investment is of doubtful validity in practice.

6. Ceiling fails to explain adequately the onset of Depression:

Hicks has been criticised for his explanation of the ceiling or the upper limit of the cycle. According to Duesenberry, the ceilling fails to explain adequately the onset of depression. It may at best check growth and not cause a depression. Shortage to resources cannot bring a sudden decline in investment and thus cause a depression. The recession of 1953-54 in America was not caused by shortage of resources. Further, as admitted by Hicks himself, depression may start even before reaching the full employment ceiling due to monetary factors.

7. Explanation of Floor and Lower Turning Point not Convincing:

Hicks’s explanation of the floor and of the lower turning point is not convincing. According to Hicks, it is autonomous investment that brings a gradual movement towards the floor and it is again increase in autonomous investment at the bottom that leads to the lower turning point. Harrod doubts the contention that autonomous invest­ment would be increasing at the bottom of the depression.

Depression may retard rather than encourage autonomous investment. Further, Hicks’s contention that revival would start with the exhaustion of excess capacity has not been proved by empirical evidence. Rendings Fels’s study of the American business cycles in the 19th century has revealed that the revival was not due to the exhaustion of excess capacity. Rather in certain cases, revival started even when there was excess capacity.”

8. Full Employment level not Independent of Output Path:

Another criticism levelled against Hicks s model is that the full employment ceiling, as defined by Hicks, is independent of the path of output. According to Demburg and McDougall, the full employment level depends on the magnitude of the resources that are available to the country.

The capital stock is one of the resources. When the capital stock is increasing during any period, the ceiling is raised. “Since the rate at which output increases determines the rate at which capital stock changes, the ceiling level of output will differ depending on the time path of output. One cannot therefore separate the long-run full employment trend from what happens during a cycle.”

9. Explosive Cycle not Realistic:

Hicks assumes in his model that the average capital-output ratio (v) is greater than unity for a time lag of one year or less. Thus explosive cycles are inherent in his model. But empirical evidence shows that the response of investment to a change in output (v) is spread over many periods. As a result, there have been damped cycles rather than explosive cycles.

10. Mechanical Explanation of Trade Cycle:

Another serious limitation of the theory is that it presents a mechanical explanation of the trade cycle. This is because the theory is based on the multiplier-accelerator interaction in rigid form, according to Kaldor and Duesenberry. Thus it is a mechanical sort of explanation in which human judgement, business expectations and decisions play little or no part. Investment plays a leading role based on formula rather than on judgement.

11. Contraction Phase not longer than Expansion Phase:

Hicks has been criticised for asserting that the contraction phase is longer than expansion phase of trade cycle. But the actual behaviour of the postwar cycles has shown that the expansionary phase of the business cycle is much longer than the contractionary phase.

Conclusion:

Despite these apparent weaknesses of the Hicksian model, it is superior to all the earlier theories in satisfactorily explaining the turning point of the business cycles. To conclude with Demburg and McDougall, “The Hicks’s model serves as a useful framework of analysis which, with modification, yields a fairly good picture of cyclical fluctuation within a framework of growth. It serves especially to emphasise that in a capitalist economy characterised by substantial amounts of durable equipment, a period of contraction inevitably follows expansion. Hicks’s model also pinpoints the fact that in the absence of technical progress and other powerful growth factors, the economy will tend to languish in depression for long periods of time.” The model is at best suggestive.

6. Measures to Control Business Cycles or Stabilisation Policies

Various measures have been suggested and put into practice from time to time to control fluctua­tions in an economy they aim at stabilising economic activity so as to avoid the ill-effects of booms and depressions the following three measures are adopted for this purpose.

1. Monetary policy:

Monetary policy as a method to control business fluctuations is operated by the central bank of a country. The central bank adopts a number of methods to control the quantity and quality of credit. To control the expansion of money supply during a boom, it raises its bank rate, sells securities in the open market, raises the reserve ratio, and adopts a number of selective credit control measures such as raising margin requirements and regulating consumer credit. Thus the central bank adopts a dear money policy. Borrowings by business and trade become dearer, difficult and selective. Efforts are made to control excess money supply in the economy.

To control a recession or depression, the central bank follows an easy or cheap monetary policy by increasing the reserves of commercial banks. It reduces the bank rate and interest rates of banks. It buys securities in the open market. It lowers margin requirements on loans and encourages banks to lend more to consumers, businessmen, traders, etc.

Limitations of monetary policy:

But monetary policy is not so effective as to control boom and depression. if the boom is due to cost-push factors, it may not be effective in controlling inflation, aggregate demand, output, income and employment. So far as depression is concerned, the experience of the great depression of 1930s tells us that when there is pessimism among businessmen, the success of monetary policy is practically nil. In such a situation, they do not have any inclination to borrow even when the interest rate is very low.

Similarly, consumers who are faced with reduced incomes and unemployment cut down their con­sumption expenditure. Neither the central bank nor the commercial banks are able to induce business­men and consumers to raise the aggregate demand. Thus the success of monetary policy to control economic fluctuations is severely limited.

2. Fiscal policy:

Monetary policy alone is not capable of controlling business cycles. it should, therefore, be supplemented by compensatory fiscal policy. Fiscal measures are highly effective for controlling ex­cessive government expenditure, personal consumption expenditure, and private and public investment during a boom. On the other hand, they help in increasing government expenditure, personal consump­tion expenditure and private and public investment during a depression.

Policy during boom:

The following measures are adopted during a boom. During a boom, the government tries to reduce unnecessary expenditure on non-development activities in order to reduce its demand for goods and services. This also puts a check on private expenditure which is dependent on the government demand for goods and services. But it is difficult to cut government expenditure. Moreover, it is not possible to distinguish between essential and non-essential government expenditure. Therefore, this measure is supplemented by taxation.

To cut personal expenditure, the government raises the rates of personal, corporate and commod­ity taxes.

The government also follows the policy of having a surplus budget when the government revenues exceed expenditures. This is done by increasing the tax rates or reduction in government expenditure or both. This tends to reduce income and aggregate demand through the reverse operation of the multi­plier.

Another fiscal measure which is usually adopted is to borrow more from the public which has the effect of reducing the money supply with the public. Further, the repayment of public debt should be stopped and postponed to some future date when the economy stabilises.

Policy during Depression:

During a depression, the government increases public expenditure, reduces taxes and adopts a budget deficit policy. These measures tend to raise aggregate demand, output, income, employment and prices. An increase in public expenditure increases the aggregate demand for goods and services and leads to increase in income via the multiplier. The public expendi­ture is made on such public works as roads, canals, dams, parks, schools, hospitals and other construc­tion works.

They create demand for labour and the products of private construction industries and helps in reviving them. The government also increases its expenditure on such relief measures as unemployment insurance, and other social security measures in order to stimulate the demand for consumer goods industries. Borrowing by the government to finance budget deficits utilises idle money lying with the banks and financial institutions for investment purposes.

Conclusion:

The effectiveness of anti-cyclical fiscal policy depends upon proper timing of policy action and the nature and volume of public works and their planning.

3. Direct Controls:

The aim of direct controls is to ensure proper allocation of resources for the purpose of price stability. They are meant to affect strategic points of the economy. They affect particular consumers and producers. They are in the form of rationing, licensing, price and wage controls, export duties, exchange controls, quotas, monopoly control, etc.

They are more effective in overcoming bottlenecks and shortages arising from inflationary pressures. Their success depends on the existence of an effi­cient and honest administration. Otherwise, they lead to black marketing, corruption, long queues, speculation, etc. Therefore, they should be resorted to only in emergencies like war, crop failures and hyper-inflation.

Conclusion:

Of the various instruments of stabilisation policy, no single method is sufficient to control cyclical fluctuations. Therefore, all methods should be used simultaneously. This is because monetary policy is easy to apply but less effective while fiscal measures and direct controls are difficult to operate but are more effective. Since cyclical fluctuations are inherent in the capitalist system, they cannot be elimi­nated completely.

Some fluctuations may be beneficial for economic growth and others may be undesir­able. Stabilisation policy should, therefore, control undesirable fluctuations. We conclude with Keynes, “The right remedy for the trade cycles is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi­boom.”